Almost anyone who has attempted purchasing real estate has had a deal fall through, but when it happens during a 1031 exchange, the strict time crunch raises the stakes.
In a 1031 exchange, the proceeds from the sale of one real estate investment are reinvested in a like-kind investment, a transaction complicated by the fact that the new property has to be identified within 45 days after closing on the sale of the original property and the entire transaction must be completed within 180 days.
No extensions. No exceptions.
Being prepared for what could go wrong during the short time window can reduce the chance for mistakes and anxiety and increase the chance for an outcome that aligns with the reasons a 1031 exchange was pursued in the first place.
The most expedient path when a deal falls through during the initial 45-day window is to simply abandon the 1031 exchange and pay the required taxes, but that often is not a palatable route for investors who likely chose a 1031 exchange mainly to defer taxes. Up front planning is often the key to getting to the finish line of a 1031 exchange.
The Three-Property Rule
With a 1031 exchange, an individual must use the proceeds from the sale of the original property to purchase a replacement holding for an equal or great amount.
Following the sale of the relinquished property, an investor can identify a maximum of three potential replacements to reinvest the proceeds in a 1031 exchange without regard to fair market value. It’s possible to acquire all three of the properties in the exchange, but typically, there is a first, second, and third choice. If the purchase of the first choice falls through, the investor has two backup options.
The 200% Rule
To expand options beyond three properties, the 200% rule, also called the 200% of Fair Market Identification Rule, allows an investor to identify an unlimited number of replacement properties as long as the aggregate fair market value of those properties doesn’t exceed 200% of the sale price from the original property. This may be a good route if you are trying to expand your holdings and plan to purchase more than one replacement property. It’s also worth investigating if you are having trouble deciding on possible replacements or if it’s a tight real estate market and you’re worried about being able to close within 180 days.
The 95% Rule
As with the 200% rule, the 95% rule, also called the 95% Exception, makes it possible for the investor to identify unlimited replacement properties. In this instance, the investor must acquire at least 95% of the fair market value of all the properties. For most investors, it will be a balance of finding the right properties while making sure they have the investment dollars to meet the 95% fair market value requirement.
Delaware Statutory Trust (DST) as a Primary Option
If suitable, a DST is often an ideal backup plan because it’s a pooled investment in which a person owns fractional shares of a real estate trust. It can be difficult identifying the DST that best aligns with your goals, but it may alleviate the pressure of a single real estate deal falling through.
A DST can also be viewed as a primary replacement property option because it offers professional real estate management, it’s a way to expand holdings across industries or property types, and it can be an opportunity to diversify beyond owning a single property to owning a fraction of multiple assets.
At the very least, identifying potential DSTs at the start of the 45-day window could bring more confidence later if the identified replacement properties don’t pan out.
Much can go wrong during the initial 45-day window of a 1031 exchange, which is why it’s imperative to choose an experienced, reputable qualified intermediary (QI) to facilitate. The QI may be able to assist in identifying properties, can help avoid mistakes that could result in unexpected tax liabilities, and would also likely be aware of different DST opportunities. Because almost anyone can become a QI, time spent identifying the right one for your situation can be as important as identifying the right properties for your 1031 exchange.
For more information on 1031 exchanges and DSTs, do not hesitate to contact our team.